Nobel Prize for economics awarded to Oliver Hart and Bengt Holmström

The two economists were named by the Royal Swedish Academy today for their work on contract theory

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The Nobel Prize for Economics has been won by a British-American and a Finn for their pioneering work on contract theory.

Oliver Hart and Bengt Holmström were named by the Royal Swedish Academy of Sciences in Stockholm today.

Mr Hart, 68, is Professor of Economics at Harvard University and Mr Holmström, 67, is Professor of Economics at the Massachusetts Institute of Technology.

The pair will share the 8m Swedish krona (£747,000) prize between them.

"Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions," the Academy said.

Contract theory concerns the way economic actors construct contractural arrangments, usually working with imperfect information.

"Contract theory does not necessarily provide definitive or unique answers to these questions as the best contract will typically depend on th specific cicumstances and context. However, the power of the theory is that it enables us to think clearly about the issues involved," said the Academy.

In response to the news Mr Hart today said: "I woke at 4.40am and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang".

"I feel very lucky and grateful. I certainly did not expect it, at least at this time," said Mr Holmström.

In a 1979 paper Mr Holmström suggested that in an optimal contract a chief executive's pay should be benchmarked to their firm's performance relative to peer companies because simply linking compensation to the firm’s share price will reward the manager for good luck and punish them for bad luck.

Such benchmarking is now standard in the remuneration contracts of executives of listed companies and the majority of their pay often takes the form of share and cash bonuses.

However, Mr Holmström in that paper also suggested that in high-risk industries where the manager's performance was harder to measure pay should be skewed to fixed salaries.

In a news conference today Mr Holmström said large bonuses to executives awarded under modern contracts were "too complicated", although he declined to say whether or not the sums paid out were too high.

Mr Hart's work has focused on "incomplete contracts", where agreements are not detailed enough to cover every eventuality.

He has also explored whether services such as health, education and penal correction are better provided by the public or the private sector.

Talking about his work Mr Hart said: "Contracts are just an incredibly powerful way of thinking about parts of economics. They’re just fundamental to the whole idea that trade is a quid pro quo and that there are two sides to a transaction”.

The Academy said: "Thanks to the work of Oliver Hart and Bengt Holmström, we now have the tools to analyse not only contracts’ financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties. The contributions by the laureates have helped us understand many of the contracts we observe in real life."

The economics prize is the only Nobel not created by the Swedish dynamite inventor and philanthropist, Alfred Nobel, in the late 19th century and was only launched in 1968.

The Nobel prizes for physiology, medicine, chemistry and peace were awarded last week.

This year the peace prize went to the Colombian President Juan Manuel Santos for his peace deal with the Farc rebels, despite the fact that the agreement was rejected in a shock national referendum result only days earlier.

The literature Nobel will be awarded on Thursday.

Fifty five of the 76 Nobel economics awards are gone to people with US citizenship, although that includes dual nationalities.

Last year's winner of the Nobel economic prize was Angus Deaton, like Mr Hart, another British-born economist who now works in the US.

Mr Hart moved to the US in 1984. Mr Holmström has been on the faculty of MIT since 1994.